GOING CONCERN VERSUS ASSETS VERSUS SHARES
4.3 Tax Implications Hidden in the Purchase and Sale Agreement Gone are the days where all that was required was that the business was
4.3.2 Goodwill
Goodwill is the amount paid in excess of the tax value (book value) of the tangible assets. This is treated as a receipt of a capital nature in the hands of the seller. The seller must be aware that the structuring of the purchase and sale agreement can also turn this so-called capital revenue into taxable revenue in his hands. Conversely the purchaser will not be able to claim a deduction in respect of this capital payment. Turning this so-called capital payment into a revenue payment was seen in Deary v CIR (1920 SATC 92), where Deary sold his business to his three clerks who between them could not pay the price of the business including the goodwill let alone raise the finance to do so.·
An agreement was drawn up stating amongst other things that Deary would have a share in the profits of the business to the value of 25% for as long as the clerks owed Deary money in terms of the sale. The issue that came before the court was whether Deary was liable for tax on his quarter share of the profits. Deary rightly argued that the sale of goodwill was a capital item.
The court held that the income in Deary's hands consisted of profits from the business and on those grounds was revenue in nature and therefore taxable.
What resulted out of this case and subsequent cases is the sale of a capital asset can result in the seller being taxed on the revenue received, provided there is a link between the consideration itself, which is being received by the seller and the income of the purchaser.
Should the purchaser want to be assured of the so-called profits in a business he can make representation to the seller indicating that he would like to pay the goodwill off against the profits. In order to overcome the above mentioned problem of the payments of goodwill being paid in this manner the following would have to be implemented.
The purchase and sale agreement would have to state that X amount is being paid for goodwill, however this will be paid in annual instalments equivalent to a certain percentage of the profits of the business provided there are profits in that year. This method would give the appearance that the reference to the profits is merely a means of determining the amount of goodwill to be paid in a year until the total amount of goodwill has been paid.
No matter how well the contract is drawn up, the bottom line with regards to the question of goodwill is, is this a genuine payment for the purchase of goodwill? Ifit could be proved this was not goodwill but in fact an annuity linked to the profits of the business this would be taxed in the seller's hands are great as indicated below.
Examining goodwill it can be seen there are two types, namely local goodwill and personal goodwill.
Local goodwill can best be described as to the physical location of the business. For example a business could be situated in a place where there is a high volume of people passing the premises on a daily basis and this business relies upon passing trade. For example, bottle stores, tea rooms, stationery stores and hardware stores.
Now in purchasing a business of the above mentioned type for commercial reasons it does not matter whether local goodwill is being paid or personal goodwill is being paid because of a good manager or for that matter a combination of both types of goodwill.
From a tax point of view here lies a great danger for the seller. This danger lies in section l(g)(i) of The Income Tax Act
II for the use or occupation or the right of use or occupation of land of buildings;II
This section has been invoked successfully by the commissioner to tax the seller of the business on his goodwill in the past. If the seller sells his business for a certain price and over and above that price is an amount for goodwill, the seller has attached goodwill due to the fact of his location, goodwill known as local goodwill. The seller has a lease agreement with the landord for the next few years or alternatively owns the building and the goodwill is a right to use the premises. Revenue authorities could act upon this. It could be said, the seller has sold the right to the purchaser for the use of the premises and tax the seller accordingly.
One way to overcome this problem is for the seller who is renting the premises to negotiate a new lease with the landlord. In this way it relieves
the original owner of the business from the terms and conditions of the lease he had. This leaves the seller free to ensure the goodwill is capital in nature.
Should the original owner of the business either own the premises or sub lease the premises to the new owner! then he will be liable for tax on the subleasing. Goodwill could then be nullified and it would turn from being a capital sale into a receipt of revenue, which thus becomes taxable.
Personal Goodwill revolves around the name of the business, the reputation of the business and the reputation of the owner / managers of the business.
From the purchaser's point of view it does not matter whether the amount being paid above the value of the tangible assets is due to personal goodwill, local goodwill or a combination of the two.
The most important point is from the side of the seller because as discussed above the seller can be taxed on the goodwill payments should it be proved these are not capital payments but rather revenue payments.